Watch the markets in February for crop insurance decisions

Have you made your decision yet about crop insurance for 2013? Many of you will renew the Revenue Protection policy which has an automatic harvest price option without added premium. And many farmers who have not been crop insurance subscribers will be visiting with an agent in the next several weeks to get information and the necessary education about how it all works.

For now, we have entered the period that will determine the spring guarantees, so watch what the new crop contracts for corn and soybeans do during February.

February 1 began the calculation period for spring crop insurance guarantees. There will be 18 more trading days to determine what the average of closing prices will be. Dec 2013 corn futures closed at $5.92 and Nov 2013 soybean futures closed at $13.32 on Friday.

Those prices exceed the spring guarantees of 2012, which were $5.68 and $12.55. While you may have preferred $8 and $15, IL ag economists Gary Schnitkey and Bruce Sherrick say, “One effect of the drought and shorter crops in 2012 is that starting prices available for insurance are relatively more attractive than levels likely had a large crop been produced in 2012.”

Market uptrend during February

There could be a market uptrend during February. Schnitkey and Sherrick say, “Suppose prices trend steadily upward during February and the resulting average projected prices used to establish insurance values are below the current futures prices around March 1. In that case, there is already an increased likelihood that the harvest prices will be higher than the projected prices and insurance products that include harvest price options for guarantee increases are therefore relatively more attractive.”

Market downtrend during February

There could also be a market downtrend during February. Schnitkey and Sherrick say, “If, prices generally decline in February, then the projected price will be above the market's estimate of actual (crop) value and the use of insurance will start somewhat more "in the money" or more likely to result in payments. Secondly, the prices and volatilities can have large impacts on the premiums paid and the guarantee levels available for insurance.”

Market volatility influences the premium.

Higher option volatility, or more likely larger price movements, result in higher costs of insurance and lower volatilities result in lower costs of insurance. Schnitkey and Sherrick advise, “The prices and volatilities can have large impacts on the premiums paid and the guarantee levels available for insurance. For example, under a $5.70 projected price and .20 volatility, the cost per acre of Enterprise Unit RP insurance at an 85% coverage level would be $18.09/acre. If instead, projected prices were $6.10 and volatility were .24, the cost per acre would be $24.64, a 36% increase. The premiums can be particularly sensitive to changes in volatility.”

Two cents per bushel is all you save by shifting from Revenue Protection to Yield Protection crop insurance or excluding the harvest price option from RP, says KS St. risk management specialist Art Barnaby. He says a common price election is used and any increase in premiums or indemnity payment greater than YP’s premiums and indemnity are caused by just price risk. He says some agents recommend the reduced coverage, but he says you lose price protection.

Barnaby’s argument assumes your familiarity with advanced options trading, since crop insurance formulas are based on option puts and calls. He says, “Effectively RP is YP plus a Yield Adjusted Asian put (YAA put) (revenue endorsement) plus a Yield Adjusted Asian call (YAA call) (harvest price endorsement). The YAA put protects against falling prices and a YAA call protects against price increasing and eliminates any negative values in the YAA put.” It should be noted that Asian options are an average over time, CME options are a point in time.

How do you do that?

Barnaby says, “Farmers can write covered options against the RP contract. This is similar to a bear spread where the farmer buys an at-the-money put and sells an out-of-the-money put to lower the premium cost. One can do something similar by buying RP and then selling options out-of-the-money. If the market moves against the farmer then either he will collect from RP or he will produce a yield greater than his APH yield. In addition, this common price discovery will limit risk for farmers who want to take advantage of selling covered puts in addition to marketing their crops.”

Summary:

Spring guarantees for crop insurance on Cornbelt row crops is being set in February based on closing prices for December corn and November beans. In addition to the closing price, guarantees are also calculated with the help of market volatility and volatility not only affects the spring guarantee, but also the premium paid by farmers. To reduce premium costs, some agents have recommended downgrading to yield protection from revenue protection. However, there is very little savings and the price protection is lost.